장외파생금융거래에 사용되는 ‘ISDA 기본계약서’상의 선행조건 조항 - 계약해석 및 도산법상의 쟁점을 중심으로 -
What if Your Creditor is in Default: Condition precedent of the ISDA Master Agreement
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Section 2(a)(iii) of the ‘ISDA (International Swaps and Derivatives Association) Master Agreement’, which is a standard contract form used in most international financial derivatives contracts, provides that each payment obligation of each party is “subject to the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing.” This so-called ‘flawed-asset clause’ (“Condition Precedent”) has been one of the most controversial issues on derivatives contracts that came up after the bankruptcy of Lehman Brothers. The function of Condition Precedent can be analyzed in two ways. Firstly, it reduces the credit risk of non-defaulting party. This is similar to the right of the obligor in executory contracts provided in the section 536(2) of Civil Code of Korea, which exempts the obligor if the counter party cannot reasonably be expected to perform its own obligation. Secondly, by permitting the non-defaulting party not to perform, Condition Precedent allows her to determine when to exercise the right to Early Termination of the master agreement, and gives her breathing space. Accordingly, this provision does not preclude the Early Termination or the settlement of defaulted contracts; rather, this provides the preparatory phase of Early Termination. In the face of the bankruptcy of Lehman Brothers and the Great Recession, however, non-defaulting parties who were out of money refused to either perform their payment obligation in pursuance of the Condition Precedent or give the notice of Early Termination, which resulted to the prolonged unsettlement of those defaulted transactions. This seemed to be too harsh for the defaulting party, and several interpretations limiting the way Condition Precedent operates were brought up, bringing conflicting court decisions in England. These issues include: whether payment netting, provided in section 2(c) of the Agreement, could apply when the Condition Precedent is not satisfied; whether the Condition Precedent is of an ‘once-and-for-all’ character; and what happens to the payment obligation if the Condition Precedent is not satisfied until the maturity date. It seems that on most of those issues, under contract law of Korea, which takes a rather textualistic approach to contract interpretation, the Condition Precedent would be interpreted similar to the most recent English decision, in which the court stressed “commercial reasonableness.”Moreover, there have been several attempts to limit Condition Precedent where the Event of Default is a “bankruptcy,” in which case the Condition Precedent results in depriving the insolvent party of his right to payment, the asset which could have been available to other creditors pari passu. In this regard, applying Condition Precedent to the insolvent counter party provokes “anti-deprivation principle” in England and “prohibition of ipso facto clause” in the US Federal Bankruptcy Act. Although no provision in the Rehabilitation and Insolvency Act of Korea, which governs the insolvency procedure commenced in Korea, prohibit the ipso facto clause, the Condition Precedent would be invalid in two exceptional cases: where a non-defaulting party neither pays nor gives Early Termination notice for such a long time that this kind of opportunistic behavior is deemed as abandoning the right to safe-harbour clause in the Act; and where the relevant master agreements govern only the transactions such as prepaid swaps or plain vanilla options. As regards to the latter, since a non-defaulting party has no possibility of bearing credit risk in such transactions, the Condition Precedent does not function as intended; therefore, the interests of insolvent’s other creditors should prevail.
Abstract
Section 2(a)(iii) of the ‘ISDA (International Swaps and Derivatives Association) Master Agreement’, which is a standard contract form used in most international financial derivatives contracts, provides that each payment obligation of each party is “subject to the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing.” This so-called ‘flawed-asset clause’ (“Condition Precedent”) has been one of the most controversial issues on derivatives contracts that came up after the bankruptcy of Lehman Brothers. The function of Condition Precedent can be analyzed in two ways. Firstly, it reduces the credit risk of non-defaulting party. This is similar to the right of the obligor in executory contracts provided in the section 536(2) of Civil Code of Korea, which exempts the obligor if the counter party cannot reasonably be expected to perform its own obligation. Secondly, by permitting the non-defaulting party not to perform, Condition Precedent allows her to determine when to exercise the right to Early Termination of the master agreement, and gives her breathing space. Accordingly, this provision does not preclude the Early Termination or the settlement of defaulted contracts; rather, this provides the preparatory phase of Early Termination. In the face of the bankruptcy of Lehman Brothers and the Great Recession, however, non-defaulting parties who were out of money refused to either perform their payment obligation in pursuance of the Condition Precedent or give the notice of Early Termination, which resulted to the prolonged unsettlement of those defaulted transactions. This seemed to be too harsh for the defaulting party, and several interpretations limiting the way Condition Precedent operates were brought up, bringing conflicting court decisions in England. These issues include: whether payment netting, provided in section 2(c) of the Agreement, could apply when the Condition Precedent is not satisfied; whether the Condition Precedent is of an ‘once-and-for-all’ character; and what happens to the payment obligation if the Condition Precedent is not satisfied until the maturity date. It seems that on most of those issues, under contract law of Korea, which takes a rather textualistic approach to contract interpretation, the Condition Precedent would be interpreted similar to the most recent English decision, in which the court stressed “commercial reasonableness.”Moreover, there have been several attempts to limit Condition Precedent where the Event of Default is a “bankruptcy,” in which case the Condition Precedent results in depriving the insolvent party of his right to payment, the asset which could have been available to other creditors pari passu. In this regard, applying Condition Precedent to the insolvent counter party provokes “anti-deprivation principle” in England and “prohibition of ipso facto clause” in the US Federal Bankruptcy Act. Although no provision in the Rehabilitation and Insolvency Act of Korea, which governs the insolvency procedure commenced in Korea, prohibit the ipso facto clause, the Condition Precedent would be invalid in two exceptional cases: where a non-defaulting party neither pays nor gives Early Termination notice for such a long time that this kind of opportunistic behavior is deemed as abandoning the right to safe-harbour clause in the Act; and where the relevant master agreements govern only the transactions such as prepaid swaps or plain vanilla options. As regards to the latter, since a non-defaulting party has no possibility of bearing credit risk in such transactions, the Condition Precedent does not function as intended; therefore, the interests of insolvent’s other creditors should prevail.
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